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The Pashas of the hedge-fund universe have failed to deliver that extra return for which they are so amply compensated, year in and year out. In the first nine months of this year, for example, the HFRI Equity (Total) index was down 5.3%, compared with a 1.3% gain for the S&P 500, according to Hedge Fund Research. Slowly, top pension funds are beginning to push back, insisting that hedge funds align fees more fairly with performance.

"I am confident that most institutional investors are at least trying to negotiate, not just fees, but legal terms and fund-governance issues," says Larry Powell, deputy chief investment officer of the Utah Retirement Systems, which has about $20 billion under management.

Until recently, the rule of thumb for hedge-fund fees was 2% annually of assets under management and 20% of profits. Investors could withdraw money quarterly. But since 2008, the two and 20 rule has been under siege. "Frankly, I am not sure where the two and 20 number emanated from, as I have almost never paid two and 20, certainly not since 2008," said Powell. "I think the compensation structure has changed in the industry from one size fits all, to one of customization."

Powell and the Utah Retirement Systems have been in the forefront of the push to better square fees with performance. "I don't think anyone is quite as aggressive as we have been. Even at the height of the hedge-fund mania in 2006 and 2007, I was negotiating and receiving concessions from managers on both fees and legal terms." The poor absolute performance and shenanigans that took place in 2008, Powell says, were the catalysts he needed to institutionalize the alignment of interest between pension fund managers and hedge funds.

A SIDE ISSUE THAT HAS ARISEN in discussions among institutions is the possible issuance of special options on appreciation rights, which might vest over the life of a hedge fund's investments. These would more closely match fees with long-term investment results, rather than annual results. After all, if a hedge fund invests in, say, a contract that won't produce a return for five years, should investors be charged a fee in every one of those years? The Internal Revenue Service has yet to sanction such a move.

There has been no reduction in fees across the board, thanks to strong bargaining by the largest funds, says Nadia Papagiannis, senior hedge-fund analyst with Morningstar, the fund-tracking firm. But the average, she notes, is now below two and 20, and some big hedge funds have addressed the concerns of pension managers by giving concessions allowing for easier exits. For example, some funds that had one-year lockups have changed to quarterly lockups with special charges. Redemption charges—up to 2% of assets—would become applicable if the money were redeemed prior to an agreed-upon length of the investment.

Institutions are able to flex their muscles for another reason. They now represent almost 60% of the new investment in hedge funds, up from about 50% prior to the meltdown. That said, not all pension funds are pushing for better terms. "Unfortunately, many investors are performance chasers and rely almost exclusively on past performance, assuming it will persist in perpetuity," says Powell. "There are a lot of smart investors; however, there are a lot more dumb ones."